MARKET TONE
The US dollar (USD) has settled into a flat range whose time span is quickly approaching the one-year mark. The lack of direction is notable, with alternating support and resistance driven by shifting expectations related to the Fed’s response to inflation and growth, respectively. The latest USD gains appear to be corresponding to the intensification of geopolitical risks and the US/Iran conflict, which we see as providing countertrend strength within the context of the USD’s multi-year bear reversal off of its 2022 peak.
We have made no changes to our FX forecast. The fundamental backdrop remains incredibly complicated as market participants assess the implications of the US/Iran conflict, posing material risks to both inflation (higher) and growth (lower). Central bank policymakers have shown renewed divergence in terms of their policy outlooks following an initially coordinated period of hawkish-leaning communication at the outset of the crisis. Fed policymakers remain dovish, maintaining a cautious preference for lower rates over time. Meanwhile, the Fed’s peer central banks are broadly more hawkish, leaning toward hikes over the medium-term as they seek to rein in inflationary pressures.
The divergence in policy rate paths remains a core pillar of our fundamental outlook. Narrowing interest rate differentials will pose a material headwind for the USD and erode a critical source of support. As such, we continue to expect broad-based weakness in the USD against all of the major developed economy currencies. The USD outlook remains weak through the second half of 2026 and into the end of our forecast horizon at the end of 2027.
Growth trends in the US are mixed and conflicted with varying signals across a range of economic data and forward-looking forecast indices. The US housing market remains challenged however we have seen a notable improvement in high-frequency indicators of manufacturing activity. The pace of activity in the services sector appears healthy and inflationary pressures remain strong across most major sectors of the economy. Employment data suggest ongoing resilience in the US labour market, though risks still remain tilted to the downside overall.
Financial conditions have been accommodative overall, and do not appear to be reflecting the ongoing concerns and high-profile media coverage of the risks in private credit. Tensions between the Federal Reserve and US administration have diminished into Q2, and market participants are shifting their attention to the nomination of Kevin Warsh for Fed Chair.
Scotiabank’s central bank forecasts remain directionally unchanged. Recent adjustments have removed one 25bp cut from the Fed outlook, anticipating one 25bp cut in Q4 2026 and another in Q1 2027. The expected terminal rate is now at 3.25% (from 3.00% previously). Kevin Warsh’s nomination presents an added risk to the Fed outlook, as his preference for traditional policy tools, conduct, and transmission mechanisms lean toward a smaller balance sheet, less communication and a policy toolkit that will primarily seek to deliver on the Fed’s mandate via interest rates. A balance sheet normalization will likely require a more meaningful offset via lower interest rates, all things equal.
Structural trends continue to favour longer-term weakness for the USD. The country’s trade and fiscal balances remain wide and historically extended. They are expected to widen further over time. Portfolio adjustment flows are an additional longer-term risk as global investors consider their over-exposure to a historically elevated USD following an extended run of tech-driven US equity market outperformance. The prospect of greater hedging activity or outright reallocation out of USD assets poses a major risk to the big dollar.
Meanwhile, the Canadian dollar (CAD) continues to make halting progress toward our forecast targets as it continues to retrace its 2024–2025 decline. The CAD made a fresh cycle high in early January, only to relinquish its early gains in the initial weeks of the US/Iran conflict that began in early March. The CAD’s recent gains have delivered a meaningful narrowing in the discount (USDCAD premium) to our fair value estimate. Fundamentals argue for a stronger CAD, and we anticipate medium-term strength as markets shake off their conflict-related concerns.
The Bank of Canada (BoC) forecast is also directionally unchanged, however the 75bps of cumulative tightening have been pulled forward into 2026 while leaving the terminal rate unchanged at 3.00%. Our USDCAD forecast is unchanged, and we continue to target 1.33 by the end of 2026 and 1.30 by the end of 2027. Trade policy uncertainty remains a major risk into the July 1st, 2026 review of the USMCA.
The EUR’s performance has been mixed following a strong start to the year. The multi-year high reached in January proved to be short-lived, initially faded on the back of worrisome FX-related caution from the ECB and subsequent pressure related to the US/Iran conflict.
The conflict has forced the ECB to adopt a much more decidedly hawkish posture in order to maintain its commitment to price stability. The rapid rate adjustment observed at the outset of the conflict has faded somewhat, however policymakers and markets are still anticipating a 25bp hike by June and another hike by September. Sterling (GBP) faces even more upside, given the complete reversal in expectations for the BoE, which have shifted from easing to aggressive tightening. The UK’s challenging fiscal situation has left it in a relatively precarious position, requiring a considerable amount of reassurance to existing debt holders and prospective bond buyers. Political uncertainty remains elevated as market participants assess the ongoing challenges facing PM Starmer, with corresponding uncertainty related to Chancellor Reeves’ future. The Japanese yen’s (JPY) prospects remain positive as we look to continued tightening from the Bank of Japan (BoJ). The arrival of PM Takaichi in early February had generated some concerns about central bank independence, however the prime minister has recently delivered a forceful public affirmation of the need for the BoJ to pursue its policy objectives in an independent manner. The government has shown considerable cooperation with the US on currency matters however, with clear attention being paid to the psychologically important 160 level in USDJPY.
For Latam FX, we note the stellar performance of both the Colombian and Mexican pesos (COP, and MXN, respectively) whose gains largely reflect the broader USD weakness and terms-of-trade gains related to the rise in the price of oil. Meanwhile, the Peruvian new sol (PEN) has seen some modest weakness related to political uncertainty following the first round of elections in mid-April as markets digest the lack of clarity surrounding the second-round candidates for the runoff in early June.
Eric Theoret, Canada 416.863.5934
FX FORECASTS
CAD FX FORECASTS
FEDERAL RESERVE AND BANK OF CANADA MONETARY POLICY OUTLOOK
FEDERAL RESERVE—HAWKS ROLL OUT THE WELCOME MAT
When Kevin Warsh chairs his first FOMC meeting on June 16th–17th he may immediately set out to change thinking on the Committee. He should be patient. At present, even our forecast for a year-end cut and one more in early 2027 needs a lot to work in its favour while several of his soon-to-be colleagues have already delivered a warning shot.
A key point of debate will be the severity of an inflation shock as tariff effects combine with uncertain transmission of higher commodity prices into core measures. Core PCE is regularly running in the 3½% to 5% m/m annualized range over the past four months including core services. Warsh contends that this is misleading in favour of trimmed inflation measures that weed out outlier price movements and that happen to be unusually low at the moment (see chart 1). The architects of one such measure offers cautions, and so did past writings of other FOMC officials.
It will take many months to settle the inflation debate during which the numbers will get hotter. For the FOMC to ease would require rapid and broad cooling, and probably a further softening of the job market.
The machinations toward slower US growth and correlated easing of employment gains are in motion. Uncertainty hangs heavily over falling cap-ex excluding AI. Household income growth is stalling. Tax refunds are disappointing. The proceeds will be spent on higher gasoline and food and saved in precautionary fashion. The wealth effect on household spending is a drag from falling real house prices. A strong dollar limits net trade’s potential. Rates are higher for longer.
Warsh is an idealist who doesn’t believe in forward guidance, appears biased toward juicing growth, views AI as disinflationary, and has moderated a bias to shrink the balance sheet. He could breathe fresh life into the Fed. He’s more likely to be quickly attacked by President Trump.
BANK OF CANADA— MORE CONVICTION
We’re doubling down on our forecast for the Bank of Canada to begin tightening monetary policy over the second half of this year. From 2.25% at present, we think the policy rate will rise to 3% by year-end.
This isn’t just a commodity play. Scotiabank Economics has forecast hikes by the end of 2026 since last November. One more was added in March in response to supply chain and commodity shocks related to the war with Iran.
The BoC just opened the door wider to a rate change (recap here). It said “…if the economy evolves broadly in line with the base case, changes in the policy rate can be expected to be small.” But in which direction?
A rate cut scenario that hinged upon higher US tariffs against Canada was presented. It lacks credibility in our view. One reason is that it would prompt excessive easing of financial conditions. With markets priced for 50–75bps of hikes this year, a 25bp cut would strike that out, add the cut, probably price 1–2 more, and result in short-term market rates plunging by 100bps or more. The effect would tank the Canadian dollar, driving more import price pressures. We also remain cautiously optimistic toward trade negotiations.
A hike scenario was also presented by the BoC and conditioned on higher-for-longer energy prices. Yet it’s not just energy prices as evidenced by the BoC’s own measure (see chart 2). Canada is importing higher incomes through higher prices for many of the products it sells with trickle down effects into domestic incomes and more resulting spending. Smaller deficits driving increased federal spending represent one such example equal to ½% of NGDP this year and ¼% next year; the BoC’s communications did not have time to incorporate this added fiscal stimulus that further merits higher rates. Inflation risk has pivoted higher.
Derek Holt, Canada 416.863.7707
NORTH AMERICA
MAJOR CURRENCIES
MAJOR CURRENCIES (continued...)
LATIN AMERICA
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FOREIGN EXCHANGE STRATEGY
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Scotiabank, together with “Global Banking and Markets”, is a marketing name for the global corporate and investment banking and capital markets businesses of The Bank of Nova Scotia and certain of its affiliates in the countries where they operate, including; Scotiabank Europe plc; Scotiabank (Ireland) Designated Activity Company; Scotiabank Inverlat S.A., Institución de Banca Múltiple, Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Casa de Bolsa, S.A. de C.V., Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Derivados S.A. de C.V. – all members of the Scotiabank group and authorized users of the Scotiabank mark. The Bank of Nova Scotia is incorporated in Canada with limited liability and is authorised and regulated by the Office of the Superintendent of Financial Institutions Canada. The Bank of Nova Scotia is authorized by the UK Prudential Regulation Authority and is subject to regulation by the UK Financial Conduct Authority and limited regulation by the UK Prudential Regulation Authority. Details about the extent of The Bank of Nova Scotia's regulation by the UK Prudential Regulation Authority are available from us on request. Scotiabank Europe plc is authorized by the UK Prudential Regulation Authority and regulated by the UK Financial Conduct Authority and the UK Prudential Regulation Authority.
Scotiabank Inverlat, S.A., Scotia Inverlat Casa de Bolsa, S.A. de C.V, Grupo Financiero Scotiabank Inverlat, and Scotia Inverlat Derivados, S.A. de C.V., are each authorized and regulated by the Mexican financial authorities.
Not all products and services are offered in all jurisdictions. Services described are available in jurisdictions where permitted by law.